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Tax Reform: What Investors Should Know

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party, nor should the analysis be considered tax advice.

The House and Senate have passed separate tax reform bills, and now must reconcile them. Reaching consensus between the two chambers won’t be easy, as there are significant differences between the two bills that will need to be resolved. However, Republican leaders are optimistic that a deal can be struck within the next few weeks.

Not surprisingly, tax reform has become a highly politicized and emotional topic, filled with noise and conflicting reports from all sides. It’s important to remember that the impact of any of these changes on your personal tax liability—assuming a final bill passes in Congress—would depend on your specific circumstances. In addition, the individual components of your tax bill, including earned income, credits, deductions, and other factors, work together, like interacting cogs. Therefore, each factor should not be assessed solely in isolation.

That said, which provisions should investors be watching most closely? While it’s hard to be certain what might be in the final bill, here are some likely changes, based on what we know about the current bills:

1. Tax brackets likely will change.

Both the House and the Senate tax bills propose changes to the ordinary income tax brackets, and in general, both attempt to shift portions of taxable income into lower tax brackets. The House bill reduces the number of tax brackets to four from seven, while the Senate tax bill keeps seven tax brackets but changes tax rates. Long-term capital gains tax rates remain essentially unchanged in both bills, and short-term capital gains  would be taxed at the adjusted ordinary income tax rates. 

Current ordinary income tax brackets compared with brackets proposed in the Senate and House bills for tax year 2018.

Source: Schwab Center for Financial Research.

Most (although not all) taxpayers would owe less under the new rules, according to analyses of the House and Senate bills by various independent think tanks, including the Tax Foundation and the Tax Policy Center. The individual impact would vary, however, based on each taxpayer’s income level, amount of itemized deductions and other factors.

While some advisors might suggest steps for investors to take based on the potential changes to tax brackets, it’s hard for us to justify taking action at this point. The proposed tax brackets are quite different in the Senate and House bills, and we’re likely to see significant changes to the brackets in the final tax bill. At this point, it’s too early to know for sure what the final brackets will be, so we don’t recommend making any significant changes to your business plans or investment decisions.

2. The standard deduction is likely to increase.

Both tax bills nearly double the standard deduction, to $12,000 from $6,350 for single filers, and to $24,000 from $12,700 for married filers. There is no difference between the Senate and House bills on the standard deduction. About 70% of taxpayers claim the standard deduction, so most taxpayers claiming this deduction likely will benefit from this proposal.

If you’re a low- or middle-income earner or household, an increased standard deduction combined with an increased child tax credit should lower your tax bill.

3. Some itemized deductions may be reduced or eliminated.

Both tax bills propose eliminating or reducing itemized deductions. These proposed changes include:

  • Removing the state and local income tax deduction
  • Limiting the property tax deduction to $10,000
  • Changing the deduction for mortgage interest
  • Changing the deduction for qualified medical expenses

For the mortgage interest deduction, the Senate bill allows a deduction for mortgage interest up to $1 million. The House bill allows a deduction for mortgage interest only up to $500,000 on new home mortgages.

For the qualified medical expenses deduction, the Senate bill continues to allow the deduction for medical expenses, and would temporarily allow taxpayers to deduct qualified medical expenses that exceed 7.5% of their adjusted gross income in 2017 and 2018, from 10% currently. The House bill eliminates the deduction for qualified medical expenses.

All else being equal, if you are a high-income earner in a high-tax state, with a mortgage and high property taxes, the elimination of some deductions could cost you. If you don’t take itemized deductions, there wouldn’t be as much of an impact.

4. The child tax credit probably will be increased.

Both the House and Senate tax bills propose to increase the child tax credit and the income level of households eligible for the credit. The Senate bill increases the credit to $2,000 from $1,000, while the House bill increases the credit to $1,600.

Tax credits are generally better than tax deductions, because credits reduce your taxes dollar-for-dollar, while deductions only lower your taxable income. This change would benefit low- and middle-income households with children.

5. The personal exemption and dependent deduction are likely to be eliminated.

Both the House and Senate tax bills would eliminate the $4,050 personal exemption and dependent deduction. There are no differences between the two bills on this issue.

When combined with the increased standard deduction and increased child tax credit, lower- and middle-income households should see a net benefit despite the elimination of these deductions. However, higher-income taxpayers could see an increased tax bill from this proposal, if they have large families and don’t qualify for the child tax credit, because of income phase-outs within the tax bills.

6. The alternative minimum tax may be changed or eliminated

Both bills propose changes to the alternative minimum tax (AMT). The House bill removes AMT altogether. In a last-minute amendment, the Senate decided not to repeal the AMT, instead increasing the amount of income that is exempt from the tax. Eliminating the AMT, or increasing the level of income before AMT kicks in, should benefit middle- and high-income households that were previously affected by this tax.  We don’t suggest major actions for most taxpayers based on potential repeal of the AMT, but consult with your tax advisor if you have specific questions or concerns.

7. Treatment and calculation of cost basis on investment sales may change.

The Senate tax bill has a provision in it that would require investors to use the “first-in, first-out” (FIFO) method to calculate cost basis for investment sales. Currently, investors have the option to select the specific shares they wish to sell, which can help to manage the taxable income generated by the sale. Depending on when investments were purchased and their cost basis, requiring investors to use the FIFO method could result in a higher tax bill for some investors.

It is not yet clear whether this proposal will end up in the final tax bill. The House bill doesn’t include it, and it faces opposition from brokerage firms that consider it unfriendly to investors.  At this point, we don’t believe investors should sell investments in 2017 in anticipation of the change, as it’s unclear whether it will be included in the final tax bill.

8. Treatment of income from “pass-through” businesses may change.

This is a complex area of tax law, and the tax bills from the House and Senate have slightly different proposals. The House bill provides some pass-through businesses, like S corporations and partnerships, with a maximum tax rate of 25%. However, it limits the types of businesses that will be allowed to claim that rate—in general, personal-service businesses like law firms, accountants and doctors won’t be able to get that 25% rate.

The Senate takes a completely different route, allowing businesses to exclude 23% of their net income from taxation. The remaining income would be taxed at the normal ordinary income rates. The Senate bill also has a provision to limit the deduction that personal service firms would be allowed: businesses like lawyers, doctors and accountants wouldn’t be able to take that 23% deduction unless their taxable income is below a certain threshold ($500,000 if married, $250,000 if single).

Overall the changes to the taxation of pass-through entities appears to be beneficial to many businesses, but a lot of personal-service businesses won’t get to enjoy the benefits of this proposal.  Due to the differences between the bills and the likelihood we’ll see significant changes, we don’t recommend making changes to businesses or business plans at this point. 

9. The corporate tax rate will likely be lower.

Both tax bills propose a reduction of the corporate tax rate to 20% from 35%, though subsequent comments from President Donald Trump suggest the White House would consider a rate as high as 22%. The House bill proposes the 20% tax rate take effect in 2018; while the Senate bill delays the 20% tax rate until 2019. Both bills want the 20% rate to be permanent.

Lowering the corporate tax rate would increase the profits of many companies, which could provide additional capital for business expansion, increase dividends to shareholders and make the U.S. a more attractive place for foreign businesses to open operations.

10. There will be no changes to tax-deferred retirement accounts

Early on in the tax debate, it was rumored that Republicans considered changes to the deductions taxpayers receive for contributing to tax-deferred retirement accounts, such as IRAs or 401(k) retirement plans. The proposal was not included in either of the bills.

What to do now?

In the coming weeks, we should see a flurry of changes to the tax bills in an attempt to craft a single cohesive bill, which will need to be passed by both the House and Senate. Until a law is passed and signed, it’s probably best to do nothing, although a year-end discussion with your tax or financial advisor is always a good idea.

Bottom line: We believe investors should not overreact to potential changes in tax law or market movements, especially if they have a long-term investment strategy and financial plan.

For more information on the proposed tax plan, see “Tax Reform: Frequently Asked Questions,” as well as ongoing commentary on events in Washington written by Michael Townsend, director of legislative and regulatory affairs for Schwab.

What you can do next

  • If you’ve already created a financial plan to achieve your goals, ignore the political noise and wait until conditions are clear before considering any changes.
  • But now might be a good time to check in with a financial consultant to make sure your plan is up to date. Call Schwab at 800-355-2162, visit a branch, or find a consultant.
  • If you haven’t yet created a financial plan, Schwab can help. Learn more about investment advice at Schwab.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Investing involves risks, including loss of principal.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.


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